Lesson 7 of 25 · 7 min
What a paper gain does to a sense of skill
Most of a large rise is usually the market showing up, and the market never signs its work.
A gain arrives as one number, and one number cannot be attributed. It contains whatever the market did, whatever the sector did, and whatever was specific to the holding, and the three arrive fused.
Self-attribution is the tendency to assign favourable outcomes to one's own judgement and unfavourable ones to conditions. Under a concentrated holding it has an obvious hook, because the position was in fact chosen, and the choice is the most memorable part of the history. What is less memorable is that the same period lifted almost everything.
Decompose it. An initial $300,000 becomes $942,000 over seven years, a multiple of 3.14 and a gain of $642,000. A broad equity index fund over the same seven years returned a multiple of 1.96, which would have produced $588,000. The part of the terminal value that a broad holding would also have delivered is $588,000 ÷ $942,000 = 62.4 percent. The part attributable to holding this thing rather than everything is $942,000 − $588,000 = $354,000, which is 37.6 percent of the ending value.
Both figures are illustrative, and the second one is the one that carries information about selection. It is also a single observation of a single holding over a single seven-year window, which is a quantity of evidence too small to distinguish skill from a favourable draw. The gain is real either way; the inference about repeatability is the part the arithmetic does not support.
This matters under a pledge for one specific reason. A sense of unusual insight into a holding raises the size of the draw a borrower is willing to take against it, and the lender's advance rate, which is set from price behaviour and nothing else, is completely indifferent to that sense.
Key terms
- Self-attribution
- Crediting favourable outcomes to one's own judgement while assigning unfavourable ones to circumstances.
- Attribution
- Splitting a return into the part a broad holding would have produced and the part specific to the choice made.
- Sample size
- The number of independent observations behind an inference. One holding over one period is one observation, whatever its size.
Worked example
Splitting a gain into the market and the choice
An initial $300,000 over seven years. The holding returns a multiple of 3.14; a broad equity index fund returns 1.96. Both illustrative.
- Terminal value of the holding
- $942,000
- Terminal value of the broad fund
- $588,000
- Total gain
- $642,000
- Share of the ending value the market supplied
- 62.4%
- Value attributable to the selection
- $354,000
$300,000 × 3.14.
$300,000 × 1.96.
$942,000 − $300,000.
$588,000 ÷ $942,000.
$942,000 − $588,000, or 37.6 percent of the total.
The gain looks like $642,000 of judgement. The part that distinguishes this holding from owning everything is $354,000, from one observation.
Check yourself
$300,000 grows to $942,000 in seven years while a broad equity index fund returns a multiple of 1.96 over the same period. How much of the ending value is attributable to the choice of holding?
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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.